Tutorial 2

Portfolio Management
Section A
1.0 Multiple Choices Questions
1.In finance, monetary asset is same as below:
A The cash and cash equivalent asset
B Asset in money market
C The asset brings monetary benefit

C is correct. Investment on the asset that brings monetary benefit or the value of the return is
accessible.

2. A German company that exports machinery is expecting to receive $10 million in three months.
The firm converts all its foreign currency receipts into euros. The chief financial officer of the
company wishes to lock in a minimum fixed rate for converting the $10 million to euro but also
wants to keep the flexibility to use the future spot rate if it is favorable. What hedging transaction
is most likely to achieve this objective?
A Selling dollar forward.
B Buying put options on the dollar.
C Selling futures contracts on dollars.

B is correct. Buying a put option on the dollar will ensure a minimum exchange rate but does not
have to be exercised if the exchange rate moves in a favorable direction. Forward and futures
contracts would lock in a fixed rate but would not allow for the possibility to profit in case the
value of the dollar three months later in the spot market
3. An online brokerage firm has set the minimum margin requirement at 55%.
What is the maximum leverage ratio associated with a position financed
by this minimum margin requirement?
A 1.55.
B 1.82.
C 2.22.

B is correct. The maximum leverage ratio is 1.82 = 100% position ÷ 55%.

The maximum leverage ratio associated with a position financed by the minimum
margin requirement is one divided by the minimum margin requirement.

4. A trader has purchased 200 shares of a non-dividend-paying firm on margin at a price of $50
per share. The leverage ratio is 2.5. Six months later, the trader sells these shares at $60 per share.
Ignoring the interest paid on the borrowed amount and the transaction costs, what was the return
to the trader during the six-month period?
A – 20 percent.
B – 33.33 percent.
C – 50 percent.

C is correct. The return is 50 percent. If the position had been unleveraged, the return would be
20% = (60 – 50)/50. Because of leverage, the return is 50% = 2.5 × 20%.
Another way to look at this problem is that the equity contributed by the trader (the minimum
margin requirement) is 40% = 100% ÷ 2.5. The trader contributed $20 = 40% of $50 per share.
The gain is $10 per share, resulting in a return of 50% = 10/20.
5. Jason Williams purchased 500 shares of a company at $32 per share. The stock was bought on
75 percent margin. One month later, Williams had to pay interest on the amount borrowed at a rate
of 2 percent per month. At that time, Williams received a dividend of $0.50 per share. Immediately
after that he sold the shares at $28 per share. He paid commissions of $10 on the purchase and
$10 on the sale of the stock. What was the rate of return on this investment for the one-month
period?
A −12.5 percent.
B –15.4 percent.
C –50.1 percent.

B is correct. The return is –15.4 percent.

Total cost of the purchase = 500 × $32= $16,000
Equity invested = 0.75 × $16,000= $12,000
Amount borrowed = 16,000 – 12,000= $4,000
Interest paid at month end = 0.02 × $4,000= $80
Dividend received at month end = 500 × $0.50= $250
Proceeds on stock sale = 500 × $28= $14,000
Total commissions paid = $10 + $10= $20
Net gain/loss = −14,000 -16,000 – 80 -20 + 250 = −$1,850
Initial investment = $12,010
Return = −$1,850/$12,010= −15.4%
6.Caroline Rogers believes the price of Gamma Corp. stock will go down in the near future. She
has decided to sell short 200 shares of Gamma Corp. at the current market price of €47. The initial
margin requirement is 40 percent. Which of the following is an appropriate statement regarding
the margin requirement that Rogers is subject to on this short sale?
A She will need to contribute €3,760 as margin.
B She will need to contribute €5,640 as margin.
C She will only need to leave the proceeds from the short sale as deposit and
does not need to contribute any additional funds.

A is correct. She will need to contribute €3,760 as margin. In view of the possibility
of a loss, if the stock price goes up, she will need to contribute €3,760 =
40% of €9,400 as the initial margin. Rogers will need to leave the proceeds from
the short sale (€9,400 = 200 × €47) on deposit.

Section B

2. 0 Lauren has a margin account and deposits $50,000. Assuming the prevailing margin
requirement is 40 percent, commissions are ignored, and The Gentry Shoe Corporation is selling
at $35 per share:
a. How many shares of Gentry Shoe can Lauren purchase using the maximum allowable margin?
2(a). Since the margin is 40 percent and Lauren currently has $50,000 on deposit in her margin
account, if Lauren uses the maximum allowable margin her $50,000 deposit must represent
40% of her total investment. Thus, $50,000 = .4x then x = $125,000. This sum represents
$50,000 of her own funds (equity) and $75,000 of borrowed funds. Since the shares are
priced at $35 each, Lauren can purchase $125,000 / $35 = 3,571 shares (rounded).

b. What is Lauren’s profit (loss) if the price of Gentry’s stock

(1) Rises to $45?
2(b). Total Profit = Total Return - Total Investment
(1) If stock rises to $45/share, Lauren’s total return is:
3,571 shares x $45 = $160,695.
Total profit = $160,695 - $125,000 = $35,695
Lauren’s profit is computed as: $160,695 - $75,000 borrowing = $85,695;
since her initial equity was $50,000, her profit is $85,695 - $50,000 = $35,695,
which is the same as we computed above.

(2) Falls to $25?

(2) If stock falls to $25/share, Lauren’s total return is:
3,571 shares x $25 = $89,275.
Total loss = $89,275 - $125,000 = -$35,725.

c. If the maintenance margin is 30 percent, to what price can Gentry Shoe fall before Lauren will
receive a margin call?
2(c)

Market Value - Debit Balance

Margin =
Market Value
where Market Value = Price per share x Number of shares.

Initial Loan Value = Total Investment - Initial Margin.

= $125,000 - $50,000 = $75,000

Therefore, if maintenance margin is 30 percent:

(3,571 shares x Price) - $75,000

.30 =
(3,571shares x Price)

.30 (3,571 x Price) = (3,571 x Price) - $75,000.

1,071.3 x Price = (3,571 x Price) - $75,000
-2,499.7 x Price = -$75,000
Price = $30.00

3. Suppose you buy a round lot of Francesca Industries stock on 55 percent margin when the stock
is selling at $20 a share. The broker charges a 10 percent annual interest rate, and commissions are
3 percent of the total stock value on both the purchase and sale. A year later, you receive a $0.50
per share dividend and sell the stock for $27. What is your rate of return on Francesca Industries?
3. Profit = Ending Value - Beginning Value + Dividends - Transaction Costs - Interest
Beginning Value of Investment = $20 x 100 shares = $2,000
Your Investment = margin requirement
= (.55 x $2,000) = $1,100

Initial Investment = 1100 +60 = 1160

Ending Value of Investment = $27 x 100 shares

= $2,700

Dividends = $.50 x 100 shares = $50.00

Transaction Costs = (.03 x $2,000) + (.03 x $2,700)

(Commission) = $60 + $81
= $141
Interest = .10 x (.45 x $2,000) = $90.00

Therefore:

Profit = $2,700 - $2,000 + $50 - $141 - $90

= $519

The rate of return on your investment of $1,160 is:

$519/$1,160 = 44.74%

4. You decide to sell short 100 shares of Charlotte Horse Farms when it is selling at its yearly high
of $56. Your broker tells you that your margin requirement is 45 percent and that the commission
on the purchase $155 is investment upfront contribution. While you are short the stock, Charlotte
pays a $2.50 per share dividend. At the end of one year, you buy 100 shares of Charlotte at 45 to
close out your position and are charged a commission of $145 and 8 percent interest on the money
borrowed. What is your rate of return on the investment?

4. Profit on a Short Sale = Begin.Value - Ending Value - Dividends -Trans. Costs - Interest
Beginning Value of Investment = $56.00 x 100 shares = $5,600
(sold under a short sale arrangement)
Your investment = margin requirement
= (.45 x $5,600) = $2,520 + 155

Ending Value of Investment = $45.00 x 100 = $4,500

(Cost of closing out position)

Dividends = $2.50 x 100 shares = $250.00

Transaction Costs = $155 + $145 = $300.00

Interest = .08 x (.55 x $5,600) = $246.40

Therefore:

Profit = $5,600 - $4,500 - $250 - $300 - $246.40

= $303.60

The rate of return on your investment of $2,675 is:

$303.60/$2,675 = 11.35%

# An investor who is short a stock on record date is not entitled to the dividend. In fact, they are responsible for paying
the dividend to the stock lender.

5. You own 200 shares of Shamrock Enterprises that you bought at $25 a share. The stock is now
selling for $45 a share.
a. If you put in a stop loss order at $40, discuss your reasoning for this action.
5(a). I want to protect some of the profit I have; should prices drop I will still have a profit of
$15/share.

b. If the stock eventually declines in price to $30 a share, what would be your rate of return with
and without the stop loss order?
5(b). With the stop loss: ($40 - $25)/$25 = 60%
Without the stop loss: ($30 - $25)/$25 = 20%